Haircuts and settlements

Gaming the system leads to losses to lenders

India’s bankruptcy process under the Insolvency and Bankruptcy Code (IBC) is relatively new, and should be seen as a work in progress. Concerns that have recently been raised about the size of the haircuts that lenders have had to take should be seen in that light. Overall, haircuts have been in the 80 per cent range — in other words, banks have lost four-fifths of the money they have lent companies that have entered the IBC process. Even the National Company Law Tribunal recently expressed surprise that Vedanta’s Anil Agarwal was “paying almost nothing” to take over Videocon Industries. But specific worries have also focused on the one-time settlement (OTS) mechanism that has been introduced in which 90 per cent of the committee of creditors (CoC) can decide to give the firm back to the promoter. The recent OTS between the promoter of Siva Industries and Holdings Ltd and its creditors, in which the promoter paid Rs 500 crore of a Rs 5,000 crore loan, is one such example.

Any further reform of the IBC process must take into account the basic motivation for its introduction: To preserve companies, as far as possible, as going concerns; to ensure that capital is not wasted or locked up in legal proceedings; and to introduce some market discipline to banks’ lending to companies. In this context, the high average for banks’ haircuts is not, per se, a negative. It is hard to argue that creditors did not deserve to lose, say, 95 per cent on their loans to Jet Airways, for example. It is also true that given that the IBC is still relatively new, many of the cases that have been resolved are the worst offenders of the boom-and-bust lending cycle of the 2000s and early 2010s. These will naturally involve larger haircuts.

The question of whether the OTS mechanism fits within the IBC framework in India is more fraught. It can be argued that since it preserves capital, and it involves the agreement of the original lenders, it is a valuable addition to the bankruptcy process. It also takes pressure off the tribunal, which is clogged up with cases. But it must be understood that in the Indian context in particular, the OTS mechanism to settle cases can be open to subversion. If, theoretically, one group of executives at a public sector bank conspired with a corporate group to make loans that turned bad, there is no reason to suppose that those same executives will suddenly be models of integrity when they have to make decisions regarding an OTS.

The theoretical possibility therefore exists that promoters could borrow money from banks, take it out of the company, and then use the OTS mechanism to have the banks take a massive haircut on the loans — all with minimal legal oversight. The ideal solution to this problem would be, of course, an incentive-compatible banking sector that lends more carefully. But until public sector banking in India occupies a far smaller share of corporate lending, such incentive compatibility is a distant dream. The government has been active in closing loopholes in the IBC that might allow promoters to game the system. There is every danger that the OTS mechanism could become one such loophole. If its purpose is to take pressure off the NCLT, the proper solution is to increase the capacity in the bankruptcy system, not to undermine its basic principles.